Evolving the Perfect Stress Test

Citigroup needed something positive. It reported increased revenue and profit during its Q1 earnings Monday, which is fortunate, given that “the global banking group could use some good news to counter the disappointment after it recently failed the Fed’s stress test,” Forbes noted last week.

Stress testing, or the U.S. Federal Reserve’s Comprehensive Capital Analysis and Review (CCAR), is a rigorous examination that delves into the health of banks via 25 crisis-simulating variables. Such variables include 13 percent unemployment and a 50 percent drop in equity prices. The test is meant to inspire confidence that — unlike in 2008 — banks today can weather harrowing storms.

But what happens when there’s no confidence in the test?

Survival of the Fit Test

A combined 96 percent of North American financial services professionals were “not at all confident” or only “somewhat confident” that stress testing addresses all of the important risks to the banking system, according to a survey Sybase released Tuesday. This was remarkably consistent with results abroad (where other testing regimes reign), such as 93 percent in EMEA and 86 percent in APAC.

The cynic in me, which is coincidentally 86 percent of me, wondered: Are these people really dismayed with stress testing as it is? Or are they dismayed with stress testing as a reality that the Fed imposed on them last month?

Despite their afore registered lack of confidence in the system, almost half of the North American respondents (46 percent) indicated that stress testing should take place at least once every six months. More impressive, 68 percent of those surveyed in EMEA and 60 percent in APAC also preferred semi-annual testing. The figure was 84 percent in the U.K.

The six-month survey sampled 185 senior managers and C-suite risk management professionals from major capital markets firms in North America, EMEA and APAC on the latest challenges facing the global capital markets industry.

Natural Correction

One big takeaway is something we’ve known all along: The market likes confidence. Another big takeaway is that the market practitioners surveyed want these tests to boost their confidence.

Stress testing will do so by identifying the weak links in the banking industry’s chain.

“These scenarios … mirror the situation witnessed during the global economic crisis of 2008, so aren’t completely implausible,” Boston-based market watcher Trefis noted last month. “So even if you’re not an investor in bank stocks, these tests can tell you which banks are best-positioned to withstand a potential economic downturn.”

It will take a while for the Fed to work out the bugs, as it would with any new, complex system that follows an international crisis. Feedback from annual tests — or twice the feedback from semi-annual tests — will help authorities in the U.S. and around the globe hone their examinations, perpetuating the toughest traits and weeding out the irrelevant.

In my bovine-themed post from earlier this year, I asked whom new regulations and their subsequent tests should try to please. It must be everyone trying to invest with confidence, from the tech-savvy firm to the day trader to the middle-class home buyer.

We can all be thankful for the recovering economy that Citi’s CEO credited with helping the New York-based holding improve its Q1 performance. But we must prepare for the worst in the meantime.